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Collateral Substitutions

Question: 
On occasion, we have had customers who want to substitute collateral (such as wanting to sell the car that is being held as collateral and substitute with another car of same or greater value). We use a substitution form which is signed by the customer. I'm questioning if that is enough. Should the customer sign a new security agreement? Also, we have a difference of opinion when it comes to filing the new lien. Some people use the date of the collateral substitution as the security agreement date and some use the original security agreement date. If the latter is used, what about the 20 days to perfect our lien?
Answer: 

Answer by Dana Turner: From logical and operational -- not legal -- standpoints, allowing any substitution will likely cloud the issues if you have to repossess the substituted item. Just as the bank shouldn't allow additions, "corrections" or deletions to signature cards, you shouldn't allow collateral substitutions. Each loan creates a separate contract between the bank and the customer. You should completely close out one loan and then create a new one for the new item.

Answer: 

Answer by Jay Bruce: You raise some good questions. The answers will vary depending onthe facts of the particular transaction (including whether it is acommercial or consumer-goods transaction) and applicable state law.

The model provisions of Revised Article 9 ("RA9") say that a securityagreement may provide for a security interest in "after-acquired"collateral. However, a security interest does not generally attach under anafter-acquired property clause to consumer goods, unless the debtor acquiresrights in such property within 10 days after the secured party gives value.In your example, if the substitute car will be used primarily for personalpurposes and it is acquired more than 10 days after the originaltransaction, it appears that you may need a new security agreement andappropriate state-law filing (e.g., lien entry) for perfection.

With respect to commercial transactions, under RA9 the attachment of asecurity interest in collateral gives the secured party rights in the"proceeds" of the collateral. RA9 defines proceeds to include "whatever isacquired upon the sale...exchange, or other disposition of the collateral"(emphasis mine). As a general rule, a security interest in proceeds isautomatically perfected if the security interest in the original collateralwas perfected (this is subject, however, to the perfection continuationrules of RA9).

In a commercial deal, the security agreement will likely expressly cover theoriginal collateral as well as proceeds and substitute collateral. If thesecurity interest was perfected by filing a financing statement, the securedparty will be perfected as to the substitute collateral for at least 20 daysand perhaps longer depending on the circumstances (including whether "cashproceeds" were used to acquire the substitute collateral). Two examples inthe Official Comments to RA9 illustrate the rules.

Example 1: Lender perfects a security interest in Debtor's inventory byfiling a financing statement covering only "inventory." Debtor sells theinventory, deposits the buyer's check and then draws its own check to payfor equipment. Because the proceeds (equipment) were acquired with cashproceeds (deposit account), perfection does not extend beyond the 20-dayautomatic period. The Official Comment does not go on to explain how toextend perfection in this example, but it appears that this may be done byfiling an amended financing statement (UCC-3) on or before the end of the20-day period to add the equipment as collateral covered by the initialfiling.

Example 2: Lender perfects a security interest in Debtor's inventory byfiling a financing statement covering "all Debtor's property." Debtor thenacquires equipment as in Example 1. Because the financing statement issufficient to perfect a security interest in Debtor's equipment, thesecurity interest in the equipment proceeds remains [automatically]perfected beyond the 20-day period.

This discussion is not intended to be a legal opinion in connection with anyspecific transaction. Other issues may be involved, for example, if theoriginal loan was a purchase money transaction, will the lender have a PMSIin the after-acquired property? The specific rules of the law should bereviewed in the context of each transaction, and legal counsel obtained ifneeded, to ensure that your secured position is not jeopardized.

First published on BankersOnline.com 4/01/02

First published on 04/01/2002

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